Academic journal article Journal of Applied Finance

US Bank Loan-Loss Provisions, Economic Conditions, and Regulatory Guidance

Academic journal article Journal of Applied Finance

US Bank Loan-Loss Provisions, Economic Conditions, and Regulatory Guidance

Article excerpt

We differentiate fundamental and discretionary loan-loss provisioning by specifying a balance sheet perspective model with two bank-specific variables and one external economic variable. Based on panel data of US commercial banks between 1990 and 2000, we find that on average, US banks are rational; that is, loan-loss provisions reflect current and projected bank losses. Average-sized banks are more forward-looking (anti-procyclical), which some researchers interpret as income smoothing. The smallest banks and the very largest banks that are "too big to fail" are more backward-looking in provisioning, which some interpret as procyclical. [G2, G21, G28]

US bank regulators require that all banks with more than $25 million in total assets report loan-loss provisions on an accrual basis in call reports filed with the regulatory authorities. Loan-loss provisioning is an essential element of bank credit risk management. It translates periodic internal and/or regulatory loan reviews into accounting entries that affect a bank's income statement via provision for loan losses and its balance sheet via an allowance for loan losses.

Based on management's knowledge of the bank's loan portfolio, the estimated amount of loan-loss provisions should be sufficient to bring the balance in "Allowance for Loan and Lease Losses" (ALLL) to an adequate level to absorb expected loan and lease losses. Loan-loss provisioning involves subjective judgments of the bankers.

Managerial discretion in loan-loss provisioning merits attention for several reasons. First, as indicated by Healy and Wahlen (1999) in their survey of earnings management studies, there is considerable evidence that banks use loan-loss provisioning either to manage earnings or to satisfy capital adequacy requirements. The allowance for loan losses is a contra asset, and the cost of provisions is comparable to the depreciation expense of fixed assets by firms. Higher provisions for loan losses reduce bank profitability, and lower provisions increase reported net income. The allowance for loan losses is also closely related to a bank's capital ratios. The current Basel Accord allows banks to include within Tier II capital an allowance for loan losses of up to 1.25% of risk-weighted assets. Deficient provisioning can diminish the reliability and the meaningfulness of bank financial data, especially data on earnings and capital ratios.

second, loan-loss provisioning may have a procyclical impact on bank lending and contribute to the instability of the banking sector and the economic environment. ALLL is designated to absorb expected credit losses. Capital, meanwhile, is a buffer for unexpected credit losses as well as for losses due to other financial and operational risks. It has been argued that the regulatory capital adequacy required by the 1988 Basel Accord actually has a procyclical impact on banks' lending behavior. Since "the very effectiveness of regulatory capital as a buffer of unexpected shocks rests on the existence of the subsidiary buffer represented by the reserves created through loan loss provisions" (Cavallo and Majnoni, 2001), different loan-loss provisioning practices will have different impacts on the procyclical nature of regulatory capital.

Finally, the securities and Exchange Commission (sec) reports that US banks have used a variety of provisioning methods in their loan-loss accounting for a long time (sec, 2001). Given the subjectivity involved, inadequate loan-loss provisioning methods can undermine the usefulness of financial statements, vitiate a credit risk management system, adversely affect the safety and soundness of banks, and even contribute to instability in the banking system.

In this article, we examine the alleged procyclicality of loan-loss provisioning and link our results to accounting and regulatory implications.

There is a credit cycle in most countries (see Berger and Udell, 2003). Lending often rises significantly during business cycle expansions and declines materially during a subsequent contraction and recession. …

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